Understanding Real Estate &

Private Equity Roles in

Sale/Leaseback Transactions

By: Jonathan W. Hipp

 The Basic Private Equity Business Model

ƒ Deal Sourcing Continuous Process

ƒ Transaction Due Diligence 6 weeks – 6 months

Pricing / Structuring

ƒ Post Transaction Portfolio 18 months – 9 years

Company Management

ƒ Portfolio Company Exit 6 weeks – Continuous

Process

2
 Deal Sourcing Basics
Targeted Deal Sources:
ƒ Targeted Calling Efforts
ƒ Industry Research / Due Diligence
ƒ Existing Co-Investors
ƒ Professional Service Advisors
ƒ Seeded Start-Up Opportunities

Potential Deal Sources:

ƒ Investment Bankers
ƒ Business Brokers
ƒ Real Estate Brokers
ƒ Attorneys

3
 Due Diligence Basics
Facets Of Due Diligence:
ƒ Financial
ƒ Management Team
ƒ Key Company Stakeholders
ƒ Industry
ƒ Undisclosed Liabilities
Due Diligence Tools:
ƒ “Proof to Cash” Book → Cash → Tax
ƒ Boots on the Ground
Due Diligence Philosophy:
ƒ Triangulate to the Truth

4
 Investment Criteria
ƒ Service Businesses with good profit and cash flow margins
ƒ Proven Business Model:
→ Revenues $20+ million.
→ Enterprise value of $20+ million.
→ Currently profitable - at a minimum profitable at the
operating level.
ƒ Proven Management:
→ Complete, competent, battle tested
→ Both industry specific & general management experience
→ Team has a significant ownership post closing
→ Operational / Tactical / Quantitative focus vs. Big Picture
or Visionary

5
 Investment Criteria - continued
ƒ Recurring Revenue Model:
→ Contractual Recurring Revenue
→ High Customer Retention Rates
ƒ Growth:
→ Is there growth opportunity?
→ Does it have a History of Sustained Growth?
ƒ High Margins:
→ Gross margins & EBITDA
→ Indicative of a well-run business with sustainable
competitive advantage.
ƒ Systems & Controls:
→ Can the Company Produce Accurate and Timely
Operational and Financial Data.
6
 Investment Criteria - continued
ƒ Return On Invested Capital (ROIC): Is it high (+20%) and can
it be sustained? Does the Company’s business model and
growth plans support the additional deployment of capital at a
high ROIC?
ƒ Strategic Competitive Advantage: Has the Company
differentiated itself from the competition? What are the threats &
opportunities?
ƒ Multiple Expansion: Do current industry conditions or
transaction pricing lend itself to multiple expansion?
ƒ Potential Return: Is the Company capable of producing 3x –
5x invested capital over a 3 – 5 year period?
ƒ Last Man Standing Test: Is this a business you would be
comfortable owning personally, forever?

7
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

The Private Equity View of Real Estate

No Love for Dirt, Sticks,

Bricks or Steel

Main Reason: Usually Holds Hostage a

Lot Of Capital in a
Low(er) Return Asset Class

8
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Question: How do you get an asset class (Real Estate) that

produces annual returns in the 8% to 12% per year to produce
private equity type returns 25% to 35% per year?

Answer: You Don’t!

Solution: Dispose of lower return assets & reallocate capital

toward higher return assets. A $10 description for this exercise
is Capital Allocation.

This solution is applicable to select private equity folks /

transactions as well as select business owners with desirable
real estate and high return growth opportunities.

9
 Private Equity & Real Estate
The View from the Private Equity Side of the Table
An Example of Capital Reallocation:
Store A
Store A Sans Real Estate
ƒ The Return on Invested Revenue $520,000 $520,000
Capital (ROIC) for Store A Rent $52,000 (C)
increases from 24% to 136% EBITDA (A) $120,000 $68,000 (D)
once real estate is sold Investment
Land $185,000
Building $265,000
ƒ Transaction proceeds of Equipment $50,000 $50,000
Total Investment (B) $500,000 $50,000
$455,000 can be deployed to
Estimated ROIC (A/B) 24.00% 136.00%
open new locations or
Notes:
reallocated toward other high Assumed Real Estate Disposition
return pursuits. - Rent @ 10% of Unit Revenue $52,000
- Priced At An 8% Cap Rate 8.00%
Gross Transaction Proceeds $650,000
Est. Net Transaction Proceeds $455,000 (E)

(C): Assumes rent factor @ 10% of Revenue sold at an 8% Cap Rate

(D): Post Closing EBITDA $120,000 less $52,000 rent
(E): Assumes 30% effective tax rate.

10
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

ƒ What if a business owner simply wants to cash out or sell & has no
interest in reinvesting in his/her business?
ƒ Disaggregating the real estate from the business and selling it in a
separate process still may make sense: Split Sale.
ƒ Most financial buyers will not ascribe a “Market Value” to real estate
that tags along in a business sale. At most 1.0X to 2.0X additional
turns of EBITDA are given by the Financial Buyer.
ƒ Splitting the real estate and selling via a sale-leaseback transaction
to a 1031 Buyer or real estate investor may do a better job of
maximizing seller proceeds.
ƒ You are effectively pulling rent from EBITDA but selling it to a
different investor (a real estate investor) for a higher multiple.

11
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Selling a Typical Business:

Multiple range with real estate increased from 3X – 5X to 5X – 7X
as real estate assets are sold along with the Business.

Revenue $5,000,000 $5,000,000 $5,000,000

EBITDA $1,000,000 $1,000,000 $1,000,000

Exit Multiple 5.00 6.00 7.00

Business Value W/ Real Estate $5,000,000 $6,000,000 $7,000,000

12
 Private Equity & Real Estate
The View from the Private Equity Side of the Table
Revenue $5,000,000 $5,000,000 $5,000,000
ƒ Transaction #1 – EBITDA $1,000,000 $1,000,000 $1,000,000
Sell the real estate.
Exit Multiple 5.00 6.00 7.00

ƒ A 10% rent factor & 8.5% cap Business Value W/ Real Estate (X) $5,000,000 $6,000,000 $7,000,000
rate is assumed for the real
Transaction #1 - Real Estate Sale
estate sale. Rent $500,000 $500,000 $500,000

Cap Rate 8.50% 8.50% 8.50%

ƒ Transaction #2 –
Sell the business. Real Estate Value (X) $5,882,353 $5,882,353 $5,882,353

Transaction #2 - Business Sale

ƒ The business multiple range is Revenue $5,000,000 $5,000,000 $5,000,000
reduced from 5.0X - 7.0X to Rent $500,000 $500,000 $500,000
3.0X – 5.0X to account for the
EBITDA $500,000 $500,000 $500,000
absence of real estate from
the Business Sale. Exit Multiple 3.00 4.00 5.00

Business Value $1,500,000 $2,000,000 $2,500,000

ƒ The Split Sale – Methodology
Total Value Of Enterprise =
yields more proceeds to seller. Business + Real Estate Values (Y) $7,382,353 $7,882,353 $8,382,353

Imputed Value Of Split Sale

(Y-X) $2,382,353 $1,882,353 $1,382,353
13
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Other Possible Benefits of Sale Leaseback Funding:

ƒ Accretion: A sale-leaseback transaction maybe mildly accretive for the
business in the near term.
→ Example – Sale-leaseback proceeds where used to retire debt.
The reduction in debt service exceeded initial rent by $80,000 /
year. Using a business valuation of 3.0X – 5.0X EBITDA, this
incremental cash flow increases the enterprise value of the
business by $240K – $400K.
ƒ As a Funding Source: Sale-leaseback cash may be a cheaper and
more stable source of financing:
→ Initial Lease Payments maybe < Debt Service
→ Rent Increases every 5 years vs. Monthly for variable rate bank
debt
ƒ Leaseback financing (Lease) usually has less reporting & operating
restrictions than bank debt.
ƒ In troubled times a real estate investor maybe easier to work with than
a bank.
14
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Selling the real estate in a sale-leaseback transaction does

not necessarily mean the business needs to be sold. Nor
does it mean all cash proceeds need to be reinvested into the
business. As long as the Seller continues to have significant
value or stake in the underlying business, proceeds from the
real estate sale can be used for a variety of recapitalization
activities.
ƒ Provide Liquidity to the Owner – “Chips Off the Table”
ƒ Cash Out an Inactive Partner
ƒ Make the business more “affordable” for the next
ƒ Generation of family members or tier of management

15
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Real Estate Disposition Highlight Reel:

ƒ One transaction enabled a Company to pay off 1/2 of outstanding

indebtedness and distribute all invested capital back to investors.
ƒ A second transaction enabled a Company to pay off all outstanding
indebtedness and created an additional $1,000,000 to $1,600,000 of
equity value for investors.
ƒ A third transaction allowed a Company to retire 100% of outstanding
indebtedness, increase cash from operations by $600,000 per
annum and raise a $5,000,000 funding commitment for new unit
development.

16
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

The Realities of the Sale Leaseback Transaction:

It is Not All Sunshine & Lollipops

ƒ Sale Leaseback transaction is not for all business / real

estate owners.
ƒ Using the Split Sale Leaseback transaction takes much
longer to exit a Company.
ƒ There are many transaction derailers to frustrate the
process.

17
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Questionable Sale Leaseback Candidates:

ƒ Real Estate that would be a Challenging Investment regardless of the Tenant:
→ Environmental Issues
→ Title Issues
→ In Need of Significant Capital Improvements to Remain Serviceable
→ Currently Clouded by Litigation
→ Easements Need to be Renegotiated
ƒ Businesses with Volatile Revenue & Cash Flow
ƒ Businesses with Variable & Large Maintenance CAPX Requirements
ƒ Businesses with Large Working Capital or Seasonal Working Capital Needs
ƒ Businesses that have Employed Too Much Leverage
ƒ Businesses that are Not Well Run/Run to the Detriment of Other Stakeholders
ƒ Businesses in Industries/Markets that are Undergoing Significant Changes

18
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

A Split Sale Leaseback / Business Sale takes much longer to

execute. In a strong market expect the real estate disposition to
take an extra 90 days. In a struggling market, it could take a full
year. Not all Stakeholders will find this acceptable.
Potential Transaction Hazards:
ƒ Bank Covenants ƒ Bank Yield Maintenance Provisions

ƒ Bank Prepayment Penalties ƒ Hedging Arrangements

ƒ Syndicated Bank Loans ƒ Uncooperative Minority Investors

ƒ Franchisor(s) Rights / ƒ Inexperienced Professional Advisors –

Agreements Accountant / Legal / Tax

ƒ Special Permits / Licenses That

Tack To The Real Estate

19
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Sale Leaseback Issues – A Personal Perspective:

ƒ Working a transaction with syndicated debt can be

challenging.
ƒ Focus on projected net after tax proceeds not gross
proceeds.
ƒ Get in front of issues with line employees and other
stakeholders.

20
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Sale Leaseback Issues – Business Owner Post Closing

Considerations:
ƒ Fewer Fixed Assets = Less Debt Capacity
ƒ Lease must be structured to guarantee long term access to site hosting
business activity. Landlord #1 maybe low maintenance but subsequent
landlord(s) could have agendas. ROFR in lease preferred construct for
dealing with this.
ƒ If Sales Leaseback is used as a debt refinancing tool, at some point lease
expense will surpass debt service – will the host business support this added
cash outflow?
ƒ Maintain flexibility to exit business with favorable lease assignment language.
ƒ Sale Leaseback tenant guarantee(s) inhibit business owners ability to have
complete access to funds in asset sale. There is an continuing contingent
obligation.
ƒ May limit exit opportunities with marginally capitalized business buyers

21
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Sale Leaseback – Factors Critical to Success:

ƒ Clear and Realistic Client Expectations:
→Value / Transaction proceeds
→Time to close

ƒ Experienced legal, accounting & tax counsel engaged at the front end.

ƒ Pre-Packaged & up-to-date due diligence. Costs more on the front end but in
a strong market saves time

ƒ Form legal documents (PSA & Lease) that balance seller/buyer interests:
→ Helps with portfolio sale(s)
→ Assists with identifying serious buyers
→ Keeps ongoing legal fees to a minimum
→ Helps preserve seller sanity

22
 Private Equity & Real Estate
The View from the Private Equity Side of the Table

Sale Leaseback – Factors Critical to Success:

Last, but not Least:

Competent Transaction Advisors

from Start to Closing!

23
 How to Contact Us
If you would like feedback regarding a transaction of interest or if you come
across a transaction that might be of interest, please feel free to contact me:

Jonathan W. Hipp
President/CEO
11150 Sunset Hills Road | Suite 300 | Reston, VA 20190
T: (703) 787- 4714 | F: (703) 787- 4783
jhipp@calkain.com

We will act quickly to provide you feedback. Every transaction is treated with
the highest level of confidentiality.

THANK YOU!!
24